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Thursday, March 14, 2013

Top Incomes, Marginal Product, and Rent-Seeking

In thinking about what marginal tax rates to impose on those with the highest incomes, a key question is the extent to which those top incomes reflect outcome that is actually produced.For example, one story that economists often tell about higher inequality is that, because of developments in information and communications technology, and globalization it has become possible for those with superstar skill levels to produce much more--and their higher incomes reflect that increase in production. An alternative story about higher inequality is that those at the highest income levels have considerable discretion a bout negotiating their compensation, and that when a wave of deregulation, globalization, and new technology disrupts the existing arrangements for top-level pay, those with top incomes will find themselves in a position to award themselves a larger share of the pie.

There are a few jobs where it's fairly straightforward to measure what workers produce: say, installing auto windshields or picking fruit. With authors or entertainers, you can look at how many books were sold or how many tickets and downloads purchased. But for many of those with top incomes, it is quite difficult to measure exactly what is produced, and so the evidence about whether top incomes primarily reflect output or what economists call "rent-seeking" depends on interpretations of indirect evidence. David Grusky has an interesting interview with Emmanuel Saez called "Taxing Away Inequality," which explores these issues. It appears online at the Boston Review website, and also has a link to a 42-minute presentation that Saez gave in January on "Income Inequality: Evidence and Policy Implications."

Saez believes that rent-seeking is a big explanation for the higher pay at the top levels that is driving greater inequality. Here are some of his comments from the interview.

"The changes in income concentration are just too abrupt and too closely
correlated with policy developments for the standard story about pay
equaling productivity to hold everywhere. That is, if pay is equal to
productivity, you would think that deep economic changes in skills would
evolve slowly and make a gradual difference in the distribution—but
what we see in the data are very abrupt changes. Basically all western
countries had very high levels of income concentration up to the first
decades of the 20th century and then income concentration fell
dramatically in most western countries following the historical
narrative of each country. For example, in the United States the Great
Depression followed by the New Deal and then World War II. And I could
go on with other countries. Symmetrically, the reversal—that is, the
surge in income concentration in some but not all countries—follows
political developments closely. You see the highest increases in income
concentration in countries such as the United States and the United
Kingdom, following precisely what has been called the Reagan and
Thatcher revolutions: deregulation, cuts in top tax rates, and policy
changes that favored upper-income brackets. You don’t see nearly as much
of an increase in income concentration in countries such as Japan,
Germany, or France, which haven’t gone through such sharp, drastic
policy changes. ..."

"We know that in the long run economic growth leaves all incomes growing.
If you take as a century long picture, from 1913 to present, incomes
for all have grown by a factor of four. But then when you look within
that century of economic growth, the times at which the two groups were
growing are strikingly different. From the end of the Great Depression
to the 1970s, it’s a period of high economic growth, where actually the
bottom 99 percent of incomes are growing fast while the top 1 percent
incomes are growing slowly. It’s not a good period for income growth at
the top of the distribution. It turns out that that’s the period when
the top tax rates are very high and there are strong regulations in the
economy. In contrast, if you look at the period from the late ’70s to
the present, it’s the reverse. That’s a period when the bottom 99
percent incomes are actually growing very slowly and the top 1 percent
incomes are growing very fast. That’s exactly the period where the top
tax rates come down sharply. So, of course this doesn’t prove the
rent-seeking scenario but it is more consistent with it than with the
standard narrative. ..."

"For top earners, we need more research, but I have yet to see a study
that shows me that when you increase top tax rates, top earners work
less. An interesting study that was done by Robert Moffitt and Mark
Wilhelm using the tax overhaul of 1986—Reagan’s big second tax reform.
The study showed that when Reagan cut the top tax rate, pre-tax top
income surged, but the authors looked at the hours of work of those high
earners and couldn’t see any effect on their reported hours. Of course,
it was a small sample, but I hope that in the future, researchers can
look at margins like retirement—do highly paid executives retire earlier
now that Obama has raised their tax rates? That’s exactly the type of
study we need. And of course I would revise my views if you showed me
convincingly that those top guys are indeed working a lot less."

When it comes to higher marginal tax rates as a way of reducing inequality, Saez says: "Tax policy is blunt, but it works."

One argues with Saez at one's peril, so rather than making declarative statements about inequality and taxes and rent-seeking, I will just raise a few queries. 1) Some proportion of high
earners--granted, probably not a majority--are innovators who may well
provide social benefits in excess of their incomes. As Saez notes,
higher marginal tax rates are a blunt tool. The Bible verse tells about
how it rains on the just and unjust alike; in a similar spirit, higher
marginal taxes will fall on the productive and the rent-seeking alike.

2) I suspect that 21st-century tax lawyers are an altogether different breed than tax lawyers who operated during the high marginal tax rates of the 1930 and 1940s and 1950s--more aggressive, sophisticated, and experimental. Thus, using the experience of higher marginal taxes and greater equality of incomes 60-80 years ago as evidence for current policy must be taken with a grain of salt. 3) Cross-country comparisons about inequality and tax rates must also be taken with a grain of salt. The version of capitalism practiced in the U.S. economy differs in all kinds of ways from the versions of capitalism practiced in, say, Japan or Germany or Sweden. 4) That said, I find myself troubled by how many top earners are paid. Many executives get stock options that pay off whether or not their company outperforms the market. Many professional investment managers are paid based on a percentage of the total assets they manage, not whether they outperform the average returns in the market. Those financial geniuses who cooked up all the complex mortgage-backed securities that went bust a few years back got very high pay and bonuses, and they didn't have to give that money back when the bubble went pop.

In some ways, I would be happier with a rule that any company can pay anyone whatever they wish, but the compensation needs to be in the form of straight salary and bonus, paid each year. No deferred pay, or hidden perks, or golden handshakes, or stock options to be cashed in later. I suspect that paying top executives in this way would reduce pay for many of them considerably--which implies that those top earners have found ways to be compensated that even they are not willing to contemplate too openly.